What Do Budget Deficits Do?

Laurence Ball
N. Gregory Mankiw

No issue in economic policy has generated more debate over the

past decade than the effects of government budget deficits. Politi-
cians of various ideologies argue that deficit reduction is critical to
the future of the United States and other major economies. Although
the economics profession is more divided over the issue, many
economists share the view that deficits are harmful, and perhaps
even disastrous.

When economists and policymakers decry deficits, they cite

diverse reasons. Thus, despite almost unanimous concern over defi-
cits, there is considerable controversy about what effects deficits
have on the economy. The goal of this paper is to clarify these
effects. Do budget deficits reduce economic growth? Threaten to
create a financial crisis? Do deficits create winners as well as losers?
If so, who are they? How large are the effects of deficits? Are deficits
merely a chronic nuisance, or do they threaten us with economic
decay and, to use Benjamin Friedman’s (1988) ominous language,
an upcoming “day of reckoning?”

To answer these questions, we proceed in several steps. The first

section presents a positive analysis of the effects of budget deficits
on aggregate economic variables such as GDP, exchange rates, and
real wages. The analysis follows the conventional wisdom as captured,
for example, in most undergraduate textbooks. In our view, the
conventional wisdom in this area is mostly on the right track.

95
96 Laurence Ball, N. Gregory Mankiw

After describing the qualitative effects of deficits, we take a stab

in the second section at quantifying the effects of recent deficits in
the United States. As usual in economics, theory is too stylized to
give precise estimates of the sizes of the effects. But some simple
calculations shed light on the orders of magnitude involved.

The third section turns from positive analysis to a consideration

of deficits and economic well-being. Our theme here is that
deficits cause redistributions: some people lose from deficits, but
others gain. It is possible to justify the common view that deficits
are undesirable over all, but doing so is not as easy as one might
think.

The fourth section turns from the question of what deficits cur-
rently do to what they might do in the future. We focus on the
possibility that continued high deficits in a country will trigger a
“hard landing” in which the demand for domestic assets collapses.
Both the likelihood of such an event and its effects are highly
uncertain. But the risk of a hard landing may be the most compelling
reason for reducing budget deficits.

Budget deficits and the economy

Suppose two countries are identical and initially both have bal-
anced budgets. Suddenly, for no good reason, one country starts
running a budget deficit, either by raising government spending or
by cutting taxes, while the other country keeps its budget balanced.
How will the evolution of these two economies differ? In particular,
how will budget deficits affect major economic variables, such as
GDP, investment, net exports, wages, interest rates, and exchange
rates?

The immediate effects of budget deficits

Budget deficits have many effects. But they all follow from a
single initial effect: deficits reduce national saving. National saving
is the sum of private saving (the after-tax income that households
save rather than consume) and public saving (the tax revenue that
What Do Budget Deficits Do? 97

the government saves rather than spends). When the government

runs a budget deficit, public saving is negative, which reduces
national saving below private saving.

The effect of a budget deficit on national saving is most likely less

than one-for-one, for a decrease in public saving produces a par-
tially-offsetting increase in private saving. For example, consider a
$1 tax cut. This tax cut reduces public saving by $1, but it also raises
households’ after-tax income by $1. It is likely that households
spend part of this windfall but save part as well. This implies that
national saving falls, but by less than the fall in public saving.1

How does lower national saving affect the economy? The answer
can be seen most easily by considering some simple (and irrefutable)
accounting identities. Letting Y denote gross domestic product, T
taxes, C consumption, and G government purchases, then private
saving is Y-T-C, and public saving is T-G. Adding these yields
national saving, S:

S = Y - C - G.

National saving is current income not used immediately to finance

consumption by households or purchases by the government.

The second crucial accounting identity is the one that divides GDP
into four types of spending:

Y = C + I + G + NX.

Output Y is the sum of consumption C, investment I, government

purchases G, and net exports NX. Substituting this expression for Y
into the previous equation for national saving yields

S = I + NX.

This simple equation sheds considerable light on the effects of

budget deficits. It says that national saving equals the sum of
investment and net exports. When budget deficits reduce national
saving, they must reduce investment, reduce net exports, or both.
98 Laurence Ball, N. Gregory Mankiw

The total fall in investment and net exports must exactly match the
fall in national saving.

To the extent that budget deficits increase the trade deficit (that is,
reduce net exports), another effect follows immediately: budget
deficits create a flow of assets abroad. This fact follows from the
equality of the current account and the capital account. When a
country imports more than it exports, it does not receive these extra
goods and services for free; instead, it gives up assets in return.
Initially, these assets may be the local currency, but foreigners
quickly use this money to buy corporate or government bonds,
equity, or real estate. In any case, when a budget deficit turns a
country into a net importer of goods and services, the country also
becomes a net exporter of assets.

At first, some of these conclusions may appear mysterious. Business

firms choose the economy’s level of investment, and domestic and
foreign consumers choose net exports. These decisions may seem
independent of the political decisions that determine the budget
deficit. If the government decides to run a deficit, what forces induce
firms to invest less and foreigners to buy fewer domestic products?

The answer is that these changes are brought about by interest

rates and exchange rates. Interest rates are determined in the market
for loans, where savers lend money to households and firms who
desire funds to invest. A decline in national saving reduces the
supply of loans available to private borrowers, which pushes up the
interest rate (the price of a loan). Faced with higher interest rates,
households and firms choose to reduce investment.

Higher interest rates also affect the flow of capital across national
boundaries. When domestic assets pay higher returns, they are more
attractive to investors both at home and abroad. The increased
demand for domestic assets affects the market for foreign currency:
if a foreigner wants to buy a domestic bond, he must first acquire
the domestic currency. Thus, a rise in interest rates increases the
demand for the domestic currency in the market for foreign
exchange, causing the currency to appreciate.
What Do Budget Deficits Do? 99

The appreciation of the currency, in turn, affects trade in goods

and services. With a stronger currency, domestic goods are more
expensive for foreigners, and foreign goods are cheaper for domestic
residents. Exports fall, imports rise, and the trade balance moves
toward deficit.2

To sum up: government budget deficits reduce national saving,

reduce investment, reduce net exports, and create a corresponding
flow of assets overseas. These effects occur because deficits also
raise interest rates and the value of the currency in the market for
foreign exchange.

Budget deficits in the United States

So far, our discussion of budget deficits has been theoretical. Do

the effects we have discussed occur in actual experience? There is
a large empirical literature that looks for these effects. Unfortunately,
this work has neither refuted the theories we have sketched nor
convinced skeptics of their validity. The main obstacle to convincing
empirical work is the identification problem. Countries do not run
fiscal policies as controlled experiments; instead, policies change
over time in response to changing economic circumstances. It is
difficult to sort out the effects of budget deficits from their causes.

Nonetheless, it is useful to examine the U.S. experience over the

past dozen years. Table 1 provides some summary statistics. While
these data do not prove anything definitively, they show that the U.S.
experience can be explained by conventional theories. The figures
also offer a sense of the magnitudes involved.

As the top line of Table 1 shows, beginning in the early 1980s, the
U.S. government switched from a policy of (inflation-adjusted)
budget surpluses to budget deficits. Public saving fell by 2.4 percent
of GDP. Rather than rising as one might expect, private saving rates
fell slightly, suggesting that the increased impatience exhibited in
fiscal policy also infected the private sector. National saving fell by
about 2.9 percentage points.
100 Laurence Ball, N. Gregory Mankiw

Table 1
The U.S. Experience
Averages as a percent of GDP
1960-81 1982-94 Change

Public saving 0.8 -1.6 -2.4

Private saving 16.1 15.7 -0.4
National saving 16.9 14.0 -2.9
Domestic investment 16.5 15.7 -0.8
Net exports 0.3 -1.7 -2.0

Note: All variables are gross nominal magnitudes as a percentage of nominal GDP. Public
and private saving have been adjusted for the effects of inflation: only the real interest on the
national debt is counted as expenditure by the government and income to the private sector.
Net exports here are measured as national saving less domestic investment; it thus includes
the net income from domestically owned factors of production used abroad.
Source: U.S. Department of Commerce and authors’ calculations.

So far, this fall in national saving has been associated with a fall
in domestic investment of only .8 percentage point. As a result, the
U.S. trade balance went from a small surplus to a large and persistent
deficit, a fall of about 2 percent of GDP. These trade deficits have,
as is necessary, been financed by the sale of domestic assets. In 1981,
the U.S. stock of net foreign assets was about 12.3 percent of GDP;
in 1993, it was negative 8.8 percent. The world’s largest economy
went from being a creditor in world financial markets to being a debtor.

Long-run effects of deficits: output and wealth

The effects described so far begin as soon as the government

begins to run a budget deficit. Suppose, as is often the case, that the
government runs deficits for a sustained period, building up a stock
of debt. In this case, the accumulated effects of the deficits alter the
economy’s output and wealth.

In the long run, an economy’s output is determined by its produc-

tive capacity, which, in turn, is partly determined by its stock of
capital. When deficits reduce investment, the capital stock grows
more slowly than it otherwise would. Over a year or two, this
What Do Budget Deficits Do? 101

crowding out of investment has a negligible effect on the capital

stock. But if deficits continue for a decade or more, they can substan-
tially reduce the economy’s capacity to produce goods and services.

The flow of assets overseas has similar effects. When foreigners

increase their ownership of domestic bonds, real estate, or equity,
more of the income from production flows overseas in the form of
interest, rent, and profit. National income—the value of production
that accrues to residents of a nation—falls when foreigners re-
ceive more of the return on domestic assets.

Recall that budget deficits, by reducing national saving, must

reduce either investment or net exports. As a result, they must lead
to some combination of a smaller capital stock and greater foreign
ownership of domestic assets. Although there is controversy about
which of these effects is larger, this issue is not crucial for the impact
on national income. If budget deficits crowd out capital, national
income falls because less is produced; if budget deficits lead to trade
deficits, just as much is produced, but less of the income from
production accrues to domestic residents.

In addition to affecting total income, deficits also alter factor

prices: wages (the return to labor) and profits (the return to the
owners of capital). According to the standard theory of factor mar-
kets, the marginal product of labor determines the real wage, and the
marginal product of capital determines the rate of profit. When
deficits reduce the capital stock, the marginal product of labor falls,
for each worker has less capital to work with. At the same time, the
marginal product of capital rises, for the scarcity of capital makes
the marginal unit of capital more valuable. Thus, to the extent that
budget deficits reduce the capital stock, they lead to lower real
wages and higher rates of profit.

Long-run effects of deficits: future taxes

In addition to their effects on macroeconomic performance,

budget deficits have a more direct implication for the future: the
resulting government debt may force the government to raise taxes
102 Laurence Ball, N. Gregory Mankiw

when the debt comes due. These future taxes reduce household
incomes in two ways—directly through the tax payments and indi-
rectly through the deadweight loss that arises as taxes distort incen-
tives. Alternatively, if taxes do not rise, the government may be
forced to cut transfer payments or other spending to free up funds
to pay the debt.

By how much must taxes rise or spending fall to pay off a country’s
debt? This question is more tricky than it seems, for the answer
depends on both policy choices and luck. One surprising fact is that
the government may never need to raise taxes or cut spending at all.
Instead, it can simply roll over its debt: it can pay off interest and
maturing debt by issuing new debt. At first this policy might appear
unsustainable, because the level of debt increases forever at the rate
of interest. Yet as long as the rate of GDP growth is higher than the
interest rate, the ratio of debt to GDP falls over time. With the debt
shrinking relative to the size of the economy, the government can
roll over the debt forever even as its absolute size grows. That is,
the economy can grow its way out of the debt.

History suggests that a government is likely to get away with

running such a Ponzi scheme. In many developed economies, the
average growth rate over long periods has exceeded the average
interest rate on government debt. In the United States, for example,
average growth of nominal GDP from 1871 to 1992 was 5.9 percent,
and the average interest rate on debt was 4 percent. If these trends
continue, a policy of rolling over the debt (and using taxes to pay
for current government services) will cause the debt to grow more
slowly than GDP. The debt will eventually become negligible rela-
tive to the size of the economy, even with no tax increases.

Does this scenario sound too good to be true? It may be. The catch
is that the future paths of interest rates and GDP are uncertain.
Although interest rates on government debt have usually been less
than the growth of GDP, these variables fluctuate. It is possible,
although not especially likely, that the economy will experience a
run of bad luck—say a major depression—in which the growth rate
drops below the interest rate for a sustained period. In this case, a
What Do Budget Deficits Do? 103

policy of rolling over the debt will cause the debt to rise faster than
national income. Eventually, the debt may become so large relative
to the economy that the government has difficulty selling it, forcing
a tax increase or spending cut. Moreover, these adjustments are
especially painful: they are large, and they come when the economy
is already suffering from a problem that has caused the debt-income
ratio to rise.3

Thus a policy of rolling over the debt is a gamble: the government

is likely to avoid any tax increase or spending cut, but it risks large
and painful ones. Faced with this risk, the government may choose
to reduce the deficit while the debt is still moderate and the economy
is healthy. By raising taxes or cutting spending initially, the govern-
ment can reduce the risk of more difficult fiscal adjustments later.

By how much must the government raise taxes to ensure that the
debt-income ratio does not explode? One natural, safe policy is to
raise taxes enough to stabilize the real value of the debt. As long as
economic growth does not stop entirely, this policy will ensure that
the debt-income ratio falls over time. Thus, a permanent tax increase
equal to the real interest on the debt is an upper bound on the future
tax burden arising from past budget deficits, assuming the govern-
ment chooses to play it safe.

The size of the effects

We now turn from the qualitative effects of budget deficits to their

quantitative importance. Are the effects of deficits on variables such
as GDP and wages large or small? And how important are these
effects compared to other phenomena, such as the worldwide slow-
down in productivity growth? We focus on deficits of the size
experienced in the United States, which has to date accumulated a
debt of about one-half of annual GDP.

A parable

As we have discussed, government debt reduces the growth of

GDP because it crowds out capital. To see how different the U.S.
104 Laurence Ball, N. Gregory Mankiw

economy would be if there were no debt, consider the following

thought experiment. Suppose that the crowding-out process is magi-
cally reversed. One night, the debt fairy travels around and replaces
every U.S. government bond with a piece of U.S. capital. How
different would the world be the next morning when everyone woke
up? After answering this question, we argue that it provides a good
guide to the actual effects of deficits in the United States.

The debt fairy’s actions would affect four key variables: the
burden of debt service, the level of GDP, the real wage, and the return
to capital. The simplest calculation is the reduction in the debt
service. In real terms, the government has to make interest payments
of rD, where D is the debt and r is the real interest rate. These interest
payments must be financed with taxes, spending cuts, or additional
borrowing. In the United States, the average real return on govern-
ment debt is approximately 2 percent. Because debt is about half of
GDP, the debt fairy’s generosity would eliminate a debt service of
about 1 percent of GDP.

The replacement of debt by physical capital would also raise

output. Since the capital stock rises by the level of debt D, output Y
rises by MPKxD, where MPK is the marginal product of capital.
Proportionately, output rises by MPKxD/Y. In the United States, the
capital share is about 30 percent, and the capital-income ratio is
about 2.5, which implies an MPK of 12 percent. Thus, the creation
of capital by the debt fairy raises GDP by about 6 percent.4

Determining the effects on real wages and the returns to capital

requires some information about the form of the aggregate produc-
tion function. A standard view is that the production function is
roughly Cobb-Douglas. For this production function, the marginal
product of labor, which determines the real wage, is proportional to
output per person. Because output rises by 6 percent and the labor
force is unchanged, the real wage rises by 6 percent as well.

Finally, for a Cobb-Douglas production function, the marginal

product of capital is proportional to the output-capital ratio. As we
have discussed, output rises by 6 percent. For a debt-income ratio
What Do Budget Deficits Do? 105

of .5 and a capital-income ratio of 2.5, the debt fairy’s intervention

raises the amount of capital by 20 percent. Thus, the output-capital
ratio falls by about 20 - 6 = 14 percent, implying a similar fall in the
return to capital. Because the return to capital is about 12 percent
per year, it falls to about 10.3 percent per year. In the longer run over
which real interest rates are tied to the return to capital, real interest
rates also fall by about 170 basis points.

Is this the right calculation?

Our goal is to estimate how the U.S. economy would be different

today if the government had always run a balanced budget. Does the
debt-fairy experiment answer this question? The experiment is
exactly right under two assumptions: the economy is closed, and
fiscal policy does not affect the path of net private saving. With
constant saving, the sale of government debt does not alter the level
of private wealth. Each dollar of government debt in savers’ portfo-
lios crowds out a dollar of capital, and there is no inflow of capital
from abroad. Fiscal policy simply substitutes government debt for
capital, and the debt fairy reverses this process.

What if we relax the obviously false assumption of a closed

economy? In an open economy, capital inflows partly offset the
crowding out of capital by debt. These inflows mitigate the effects
of debt on GDP, the real wage, and the profit rate. For example, if
one-third of the fall in national saving is financed with a trade deficit
(a typical estimate), the fall in the capital stock is only two-thirds as
large, implying that the impacts on GDP and factor prices are only
two-thirds as large as estimated above.5 Yet, as discussed earlier,
this issue is not important for calculating the effect of deficits on
gross national product. Because GNP rather than GDP determines
the living standards of a country’s residents, the impact on living
standards is not much altered by the capital inflow induced by
budget deficits.

It is difficult to evaluate the assumption that private saving is

invariant to fiscal policy. As we have discussed, private saving
probably responds somewhat to public saving, and this effect
106 Laurence Ball, N. Gregory Mankiw

reduces the impact of budget deficits. Unfortunately, there is no

consensus on the magnitude of the effect. The Council of Economic
Advisers (1994) argues that the offset is close to zero on the basis
of the experience of the 1980s: because private saving was low in
the presence of large budget deficits, it is hard to believe it would
be much lower in the absence of deficits. On the other hand, studies
of countries with deficits of varying sizes suggest a private-saving
offset closer to one-half (Bernheim, 1987). In light of this uncer-
tainty, we view the results of our debt-fairy experiment as an upper
bound on the effects of the U.S. debt on national income. Our best
guess for the actual effect is somewhere between the debt-fairy
figure of 6 percent and half of that level.

Are these effects a big deal?

Do the numbers we have presented suggest that budget deficits

are a major economic problem or a minor one? Our subjective
assessment is somewhere in between. Our upper bound for the
effects of past U.S. deficits on current national income is 6 percent.
One way to interpret this number is to remember that average real
growth in income per capita in the United States is about 2 percent
a year. Thus reducing GNP by 6 percent is like giving up three years
of growth. In the absence of debt, the United States would have
achieved its 1995 level of income in 1992. These numbers are
certainly significant: 6 percent of current GNP is about $400 billion.
But waiting an extra three years to achieve any level of income is
hardly a disaster.

Another way to gauge the importance of deficits is to compare

their effects to those of other economic phenomena. The United
States and most other industrialized nations have experienced slow
growth for the last 20 years, relative to the previous three decades.
This slowdown in growth is behind the widely publicized stagnation
in living standards for many workers and the resulting public concern
that something is wrong with the economy. The slowdown in output
growth has been caused mainly by slower growth in total factor
productivity. Productivity growth has fallen by about 1 percent per year,
resulting today in a total shortfall relative to the past trend of about 20
What Do Budget Deficits Do? 107

percent. By comparison, the 3 percent to 6 percent fall in income

due to government debt can be viewed as only a moderate problem.

Deficits and economic well-being

Having presented a positive analysis of the effects of budget

deficits on aggregate economic variables, we now turn to the normative
questions of whether and why deficits are undesirable. Popular
discussions of deficits usually take it for granted that deficits are bad
for the economy, and perhaps even immoral. Although this view can
be defended, its justification is less obvious than one might think.

Economists are often tempted to use GNP as a shorthand measure

of economic well-being. As we have already discussed, budget
deficits do not affect GNP initially and, in the long run, reduce GNP.
Thus, by the measure of GNP, deficits are unambiguously harmful.
Yet this analysis of deficits is misleading, for economic well-being
depends on consumption rather than GNP. While deficits do not raise
GNP, they do raise consumption in the short run by lowering house-
holds’ tax burden.

If one focuses on consumption as the proper measure of well-

being, budget deficits come to look like a particular policy of income
redistribution. Redistributions occur because of the change in the
timing of taxes and because of changes in factor prices. These
redistributions do not harm everyone; instead, some people gain at
the expense of others. The gains and losses sum to zero, so it is not
obvious that deficits are good or bad overall.

Who wins and who loses?

An analogy may be helpful in thinking about the desirability of

deficits. Suppose that Californians become powerful in Congress
and pass a law that reduces taxes in California and raises them in
New York, leaving total taxes unchanged. This law does not benefit
or harm the economy as a whole; it merely redistributes income
among people. The direct effect is to benefit Californians and hurt
New Yorkers. There are also likely to be general-equilibrium effects
108 Laurence Ball, N. Gregory Mankiw

on the incomes of various groups. For example, the shift in the tax
burden from California to New York will raise the demand for
surfboards and reduce the demand for opera, leading to higher
profits for surfboard manufacturers and lower wages for singers.
These effects are called pecuniary externalities. Assuming that mar-
kets are competitive, these pecuniary externalities sum to zero, like
the direct effects of the tax change.

A policy of running deficits is similar to a pro-California tax reform:

it shifts taxes between groups. Here the shift is not between taxpay-
ers in different places but between taxpayers at different times.
When the government runs a deficit, it accumulates debt that it
must pay back through future taxation. Such a policy just shifts
the burden of taxes: current taxpayers gain, and future taxpayers lose.6

Like any shift in tax burdens, deficits have general-equilibrium

effects. Here the key effects follow from the crowding out of capital.
The fall in the capital stock affects factor prices: wages fall, harming
workers, and the returns on capital rise, benefiting capital owners.
Like the effects on the surfboard and opera industries when Califor-
nians gain power, the changes in wages and profit rates are pecuniary
externalities. The losses to workers from lower real wages are balanced
by the gains to the owners of capital from higher rates of profit.

Thus, the winners from budget deficits are current taxpayers and
future owners of capital, while the losers are future taxpayers and
future workers. Because these gains and losses balance, a policy of
running budget deficits cannot be judged by appealing to the Pareto
criterion or other notions of economic efficiency. Instead, the key
issue is whether we approve of the direction of the redistributions
that this policy implies.

Are the redistributions desirable?

Economists are not good at judging redistributions of income.

Indeed, they often claim that this issue is outside of the sphere of
economics altogether. It is, therefore, somewhat surprising that
economists decry budget deficits with such consensus and assurance.
What Do Budget Deficits Do? 109

One widely accepted standard for judging redistributions is the

ability-to-pay principle: redistributions of income are desirable if
they go from better-off to worse-off people. By this criterion, the
redistributions arising from changes in factor prices are undesirable.
Many people hold little wealth and consume the income from their
wages, while a small part of society holds most of the economy’s
wealth. When crowding out raises the returns on capital and reduces
wages, the wealthy gain at the expense of the less wealthy.

Yet, from the standpoint of the ability-to-pay principle, the direct

effect of budget deficits—the change in the timing of taxes—is
harder to reconcile with the conventional view that deficits are
undesirable. Because of technological progress, the income and
consumption of a typical individual in the economy rises over time.
Because budget deficits shift taxes forward in time, they benefit
relatively poor current taxpayers at the expense of relatively rich
future taxpayers. If reducing inequality is a goal of policy, shouldn’t
budget deficits be applauded?

One way to answer this question is to go beyond neoclassical

economic theory. Although standard models assume that people
desire to smooth consumption evenly over time, popular discussions
of economic policy presume that consumption should rise over time.
Politicians often assume a moral imperative that the current genera-
tion sacrifice to ensure that future generations enjoy a substantially
higher standard of living. This view suggests that it is undesirable
to shift a tax burden onto our children, even though our children will
be better able to shoulder that burden than we are.

Another possible answer is that levels of taxation should be based

on the benefits principle, which holds that people should pay for the
government benefits that they receive. For example, the use of a
gasoline tax to pay for road repair is not based on the abilities
to pay of drivers and non-drivers; instead, it is justified on the
ground that drivers should pay for roads because they benefit from
them. Similarly, one might argue that each generation should pay
for the government it provides itself, regardless of its level of
income.
110 Laurence Ball, N. Gregory Mankiw

These issues are not easily resolved. Yet one point is clear: saying
whether and why deficits are undesirable requires judgments that
are more philosophical than economic.

Should you worry about deficits?

A related question is whether an individual needs to rely on

politicians to avoid the future suffering caused by budget deficits.
Suppose you are worried about the effects of deficits on your
children, and aren’t confident that Bill Clinton and Newt Gingrich
will take care of the problem by balancing the budget. You can
eliminate your worries simply by saving and leaving a larger bequest
to your children, so that they can bear the burden of future taxes
without reducing their consumption.

Some economists—advocates of Ricardian equivalence—claim that

people do in fact behave this way. If this were true, private behavior
would fully offset the effects of public dissaving. Although we doubt
that most people are so far-sighted, some people probably do act this
way, and anyone could. Deficits give you the chance to consume
more at the expense of your children, but they do not require it.7

Indeed, if you are forward looking and care about your children,
deficits can benefit your family. You can insulate yourself from the
effects of tax shifting through a larger bequest. And, since you are
accumulating more capital than the typical family, you and your
children are among the winners from deficit-induced changes in
factor prices. That is, you benefit from the higher rates of return that
deficits cause.

So why should you the reader—a person who we assume both loves
his children and understands the effects of deficits—worry about
balancing the budget? Once again, answering this question requires
going beyond standard economic theory. One possible answer is
paternalism. You can protect your children from deficits, but you
know that some irresponsible parents will exploit their children to
raise their own consumption. You may care about protecting these
children’s standard of living even though their own parents do not.
What Do Budget Deficits Do? 111

Alternatively, there may be externalities from the effects of deficits

that do not appear in standard economic models. Paul Romer (1987)
and, more recently, Bradford DeLong and Lawrence Summers (1991)
have suggested that the accumulation of capital stimulates technologi-
cal change and increases economy-wide productivity. If so, then the
crowding out caused by deficits depresses national income by more
than our calculations above suggest. In addition, no single family
can insulate itself from these effects through higher private saving.

Another possible externality may arise from the distribution of

income. As discussed earlier, deficits redistribute income from wage
earners to capital owners, creating greater dispersion in wealth and
income. Perhaps widening inequality is undesirable even for the
rich. A large poor population might raise crime rates and otherwise
threaten the living standards of the wealthy. The fact that most
people—both rich and poor—prefer to live in rich communities
suggests that people care about their neighbors’ living standards for
not entirely altruistic reasons.

A related consideration is that people often care about the incomes

of their fellow citizens relative to citizens of other countries. If large
deficits reduce the U.S. growth rate, the average American standard
of living may fall behind that in Japan. It is not obvious why this
matters—why we do not care just about our own standard of living.
Perhaps a nation’s relative income matters because it affects some
sense of national prestige. Perhaps it matters because it affects
national power in world politics. Again, judging the desirability of
deficits leads to questions that economists are not particularly qualified
to address.

A hard landing?

Numerical results suggest that the effects of budget deficits are

moderate in size. Moreover, since there are winners as well as losers,
it is not obvious that deficits are undesirable overall. These conclu-
sions suggest that popular concerns about budget deficits are over-
blown, at least when the national debt is at its current U.S. level
relative to national income.
112 Laurence Ball, N. Gregory Mankiw

Matters start looking more serious if one looks ahead to future

fiscal policy. There are reasons to worry that debt-income ratios are
headed upward around the world. Many countries, including the
United States, project large deficits because of growing expendi-
tures on programs for the elderly, such as social security and Medi-
care. According to some projections, under current programs, the
U.S. debt-income ratio will reach five in 2025! Of course, the future
is uncertain: we may be saved from rising debt-income ratios by
fiscal tightening or by good luck such as high growth in income or
containment of medical costs. But what if the debt-income ratio does
keep rising?

Part of the answer is clear: the effects we have already discussed

are magnified. We have calculated that past U.S. deficits—which
have produced a current debt-income ratio of about one-half—reduce
current GNP by 3 percent to 6 percent. If the ratio rises to one, the
effect will rise to 6 percent to 12 percent.

Yet, if the debt-income ratio continues to rise, there may also be

additional effects which are qualitatively different from those the
economy is now experiencing. In particular, a rising debt-income
ratio in a country may at some point lead to a sharp decrease in
demand for the country’s assets arising from a fall in investor
confidence. In this section, we discuss how such a “hard landing”
might come about and the possible effects on the economy. Our
discussion is necessarily speculative. As far as we know, no major
industrialized country has ever experienced a hard landing of the
sort we will describe. But keep in mind: no major industrialized country
has persistently run large budget deficits in peacetime—until recently.8

How a hard landing might occur

Why might the demand for a country’s assets fall? There are two
distinct but complementary stories about how a rising national debt
could lead to lower demand for domestic assets.

The first story emphasizes the effect of deficits on a country’s

net-foreign-asset position. As we have discussed, budget deficits
What Do Budget Deficits Do? 113

tend to produce trade deficits, which a country finances by selling

assets abroad. Yet there may be limits to the quantity of domestic
assets foreigners are willing to hold. For various reasons (such as
lack of information, exchange-rate risk, or sheer xenophobia), interna-
tional diversification is far from perfect. This fact is consistent with
the finding of Feldstein and Horioka (1980) that a country’s saving
roughly balances its investment over long periods. As a country’s
net-foreign-asset position deteriorates, foreign investors may become
less and less willing to purchase additional domestic assets.

A second story is that a rising level of government debt makes

investors fear government default or a similar policy aimed at
holders of domestic assets. Unlike the first story, this story is
relevant even if a country has not reached a negative net-foreign-
asset position. And in this story, domestic as well as foreign inves-
tors flee domestic assets.

In speculating about a loss of investor confidence, one is natu-

rally led to draw on the experience of the debt crisis in less devel-
oped countries (LDC) during the 1980s. (The case of Mexico in 1994
is less relevant, because it involves imprudent monetary and
exchange-rate policy as well as debt.) In the LDC debt crisis, capital
inflows in the form of bank loans dried up when countries began
having trouble servicing their debts, leading to fears of widespread
default. It is tempting to imagine that this experience is not relevant
to countries like the United States—that rich countries would never
default. But Orange County, California is even richer than the United
States, and it is about to default on its debt. Orange County voters,
turning down a tax increase needed to honor the debt, appear to reject
the idea that they should pay for their government’s mistakes. It is
easy to imagine such arguments at the national level—or at least a
fear on the part of investors that such arguments will arise.

There is, however, a reason that the LDC debt crisis is an imperfect
guide to hard landings in the United States or European countries.
The Latin American debt was external: it was owed to foreigners.
Thus the direct effect of default was a loss to foreigners, making
default a relatively attractive way out of a fiscal crisis. The same is
114 Laurence Ball, N. Gregory Mankiw

true for Orange County: most of its debt was owned outside of the
county. In the United States, by contrast, most of the national debt
is owned by American citizens.

Since an internal debt makes default less tempting, it is likely to

delay a hard landing: it takes a higher level of debt to spook
investors. The fact that a debt is internal also affects the nature of
the prospective policies that might spark a hard landing. If the
debt-income ratio spins out of control, something must be done or
default is unavoidable. And it might remain impossible politically
to raise income taxes sufficiently. One possible outcome is a general
tax on wealth. The government might require owners of its bonds to
“share in the sacrifice” through partial default, but it would also tax
the holders of other assets. The tax could extend to foreign owners
of domestic assets to reduce the burden on domestic citizens.

An unsustainable path of debt and a worsening net foreign asset

position could lead investors to fear other unpleasant consequences
as well. Extensive foreign ownership of U.S. assets could lead to
restrictions on capital outflows. Perhaps as debt grows and wages
fall relative to those of other countries, political outrage will produce
a government that increases interference in the economy. Many U.S.
politicians, for example, are tempted to blame domestic problems
on Japanese trade practices; a trade war is not an unthinkable result
of a general decline in living standards. Similarly, many less developed
countries have unhappy histories in which economic problems cre-
ate political pressures for policies that discourage investment and
make the problems even worse. Fear of these outcomes—or just a
belief that something bad must happen if debt continues to grow—
could lead to a fall in the demand for domestic assets.

In principle, the decrease in demand for domestic assets could be

gradual, with the assets slowly becoming less popular as the fiscal
situation deteriorates. The history of financial markets suggests,
however, that shifts in investor confidence can be sudden, with the
timing driven by self-fulfilling expectations. A flight from domestic
assets could occur at a seemingly arbitrary point in time, much as
the 1987 stock market crash did. Or a hard landing could be triggered
What Do Budget Deficits Do? 115

by adverse events. In the Latin American case, the worldwide

recession of the early 1980s caused investors to revise downward
their expectations of growth and, hence, the likelihood of repay-
ment. Similarly, a crisis in the United States might be triggered by
bad news about income growth, which would imply higher debt-
income ratios for given fiscal policies.

Since a hard landing involves the psychology of markets, it is hard

to judge when it might occur. The debt crisis hit Latin American
countries with debt-income ratios below the current U.S. level of
one-half, but these countries had external debts and hence a greater
temptation to default. In addition, interest rates were much higher
for the Latin debt than for the U.S. debt, so the path of debt was
potentially more explosive. High debt-income ratios in developed
countries have previously occurred only in wartime, when they were
clearly temporary. Recent peacetime increases in the ratio are taking
the United States and other countries into uncharted territory, so it
is impossible to say whether a hard landing is around the corner or
still far off.

The costs of a hard landing

If confidence in a country’s assets collapses, what happens to the

economy? Theory and the experiences of LDCs give some guide as
to the effects. The decline in the demand for domestic assets leads
to a sharp fall in the prices of these assets, including a fall in the
stock market. Interest rates and other asset yields rise. The value of
the domestic currency falls as investors sell the currency they
acquire from selling domestic assets. As the currency depreciates,
the trade balance turns sharply toward surplus, and capital flows out
of the country.

Such a hard landing potentially harms an economy in many ways.

Most obviously, wealth falls because of the decline in asset prices.
The lack of investor confidence and higher interest rates lead to
lower levels of physical investment, and eventually a lower capital
stock. This effect exacerbates the decline in real wages caused by
budget deficits.
116 Laurence Ball, N. Gregory Mankiw

A number of other consequences might follow as well. Indeed,

hard landings are hard to think about because things can go wrong
in such a rich variety of ways. First, the rise in interest rates during
a hard landing would likely exacerbate the fiscal crisis by causing
the debt to grow rapidly. To avoid a greater disaster, the government
would have to shift abruptly to primary budget surpluses, causing a
sharp fall in consumption. That is, high interest rates would
eliminate the possibility of growing out of a debt or paying it off
slowly.

Second, the Latin American experience suggests that the shift

in the trade balance toward surplus would be a major sectoral
shock. The debt-crisis countries experienced a large shift from
nontradeables to tradeables, causing high unemployment in non-
tradeables. According to some observers, the sectoral shock
brought growth to a standstill for a decade. See Sachs and Larrain
(1993).

Third, the hard landing could lead to inflation through two distinct
channels. The drop in the domestic currency would directly push up
the prices of imports, which could trigger continuing inflation if
monetary policy is accommodative. And, in response to the fiscal
crisis, the monetary authority may feel increased pressure to raise
revenue through money creation. Both these effects were important
in producing high inflation in Latin America after the debt crisis. We
can hope that the central banks of developed countries would hold
the line against inflation even in a crisis. But if the crisis brings
extremists to power, who knows?

Finally, a hard landing could trigger a general financial crisis.

Declines in asset prices and increases in firms’ interest burdens
would increase bankruptcies. Bankruptcies of firms could trigger
financial distress for the banks that lend to them. In the worst case,
these problems and the resulting contraction of credit would build
on each other and financial intermediation would break down. As in
the 1930s, the economy could plunge into a depression.
What Do Budget Deficits Do? 117

A call for prudence

Previous sections of this paper have described well-understood

and quantifiable effects of budget deficits, such as crowding out of
capital and intertemporal shifts in tax burdens. By contrast, this
section has been highly speculative. We can only guess what level
of debt will trigger a shift in investor confidence, and about the
nature and severity of the effects. Despite the vagueness of fears
about hard landings, these fears may be the most important reason
for seeking to reduce budget deficits. If the main effects of deficits
are moderate redistributions across generations and groups of peo-
ple, perhaps they should not be a central concern of policymakers.
But as countries increase their debt, they wander into unfamiliar
territory in which hard landings may lurk. If policymakers are
prudent, they will not take the chance of learning what hard landings
in G-7 countries are really like.

Author’s Note: We are grateful to Michael Rashes for research assistance and to the National
Science Foundation for financial support.
118 Laurence Ball, N. Gregory Mankiw

Endnotes
1Economists of the “Ricardian” school argue that consumers save 100 percent of a
debt-financed tax cut, which implies that deficits have no effect on national saving. Like most
economists, we believe the added private saving is much smaller than the full tax cut. For
descriptions and critiques of the Ricardian position, see Bernheim (1987) and Gramlich (1989).
2At least since the 1960s, most economists have agreed that budget deficits create trade
deficits by causing the domestic currency to appreciate. Yet within the past year, journalists
and policymakers have argued that budget deficits cause a depreciation of the currency. In
particular, the fall in the dollar in the first half of 1995 was widely blamed on low national
savings arising from U.S. deficits. A New York Times headline proclaimed “Save the Dollar:
Encourage Saving.”
Can one make sense of this recent view? As far as we can see, the only channel through
which budget deficits could weaken the domestic currency is increased fear of the “hard
landing” discussed in the fourth section of this paper. A sharp fall in investor confidence could
cause a fall in the demand for domestic assets, outweighing the direct effect of deficits. We
are doubtful, however, that this is the right explanation for the recent fall in the dollar. Early
1995 was a period in which the likelihood of a hard landing may have fallen due to increased
interest in budget balancing by both political parties.
We suspect, therefore, that recent views about deficits and the dollar are simply fallacious.
Since budget deficits are generally viewed as irresponsible policies, it is tempting to blame
them for any undesirable event, even in the absence of a logical connection. Note that if budget
deficits weaken the dollar, they also reduce rather than increase the trade deficit, an unappeal-
ing implication that is ignored in recent discussions.
3Ball, Elmendorf, and Mankiw (1995) use the historical behavior of growth rates and
interest rates and estimate the probability of this event at 10 percent to 20 percent, under the
assumption that the debt-income ratio begins at roughly its current level.
4These calculations ignore the fact that the marginal product of capital would fall as the
level of capital rises. Formally, this means that our numbers are first-order approximations to
the effects of raising the capital stock.
5Feldstein (1992) suggests that about 25 percent of a budget deficit is typically financed by
a trade deficit, while the Council of Economic Advisers (1994) suggests 40 percent. At first
glance, the U.S. experience summarized in Table 1 suggests a larger number, since most of the
fall in national saving after 1982 was financed by a trade deficit. Yet there are probably other
factors that boosted investment and raised the trade deficit over this period. The fact that the
stock market boomed during a period of high real interest rates suggests increased investor
confidence about future profitability.

6As discussed earlier, it is possible that a government might attempt to run a Ponzi scheme
by forever rolling over its debt and accumulating interest. If such a scheme succeeds, then
deficits do not lead to higher future taxes. In this case, a policy of running deficits can yield a
Pareto improvement, for current taxpayers benefit without any loss to future taxpayers. This
possibility, however, should not be construed as an argument in favor of budget deficits, for
an attempted Ponzi scheme may fail, in which case the future tax increases are especially large
and painful. For further discussion of these issues, see Ball, Elmendorf, and Mankiw (1995).
What Do Budget Deficits Do? 119

7Herschel Grossman (1995) makes a similar argument.

8Here we draw on previous discussions of hard landings by Krugman (1991, 1992) and
Summers (1991).

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